Module Seven Lesson Two Notes

Introduction

Operating costs are just "a part of life” for every business and organization. They relate to the everyday routine, but they are anything but ordinary. Operating costs can mean the difference between profit and loss, failure and success. Prosperous businesses are mindful of operating costs and work to keep them in line.

By the end of this lesson, you will be able to identify and explain the relationship of operating costs and budgets.

Standards and Objectives

Standards

4.04 Explain the nature of overhead/operating costs (SP)

Objectives

By the end of this lesson the student will be able to:

Distinguish the relationship between operating expenses and budgets.

Guided Notes

Download your Guided Notes. Complete your guided notes as you complete your lesson.

Key Terms

Key Terms

Module Seven Lesson Two Key Terms
Term	Audio	Definition
Gross Profit		A company's revenue after subtracting the costs of the products it has sold.
Budget		An estimate of income and expense for a specific period of time.
Operations		The day-to-day activities for continued business functioning
Breakeven Point		The point at which a business's total sales equal total expenses; the business has not yet made a profit but has not incurred any losses.

Fixed or Variable Costs

Fixed or Variable Costs

As you can probably guess, certain costs may be considered either fixed or variable, depending on how you look at them. For instance, one business may consider pest-control costs to be fixed, since it spends the same amount of money each year ridding its facility of spiders and ants. Another business, however, may consider the costs to be variable, since it only spends money for pest control as needed (perhaps only once every few years). The decision of whether to categorize an expense as fixed or variable is ultimately up to the individual business. However, for accounting purposes, the decision must remain consistent over time.

Operating Costs

Operating costs have a great influence on a product’s final selling price. The total cost of a product is the sum of the overhead and direct costs required to produce it. Let’s say the total cost of producing a pair of basketball shoes is $25 ($5 in operating costs and $20 in materials). To make a profit, then, the company must set a selling price that is higher than $25. Don’t forget that there will be price markups between the manufacturer and the wholesaler, between the wholesaler and retailer, and between the retailer and the customer. The final selling price of the shoes that cost $25 to make may be $100 or more.

Operating costs have a major impact on a business's profits. As costs go up or down, profits fluctuate as well. More costs equal less profit, and fewer costs equal greater profit.

Gross Profit

A company's gross profit is the revenue it makes after subtracting the costs of the products it has sold. For example, if a company made $1 million last quarter and spent $200,000 producing its goods, its gross profit is $800,000. Gross profit is a good indicator of how well a company keeps its costs under control. You see, a similar company may also have made $1 million in revenue during the same quarter; however, it spent $300,000 producing its goods. This company's gross profit is only $700,000. It is spending more money to make the same amount of revenue. Clearly, the first company is more efficient.

A company reaches its breakeven point when total expenses equal total sales. At this point, the business has covered its costs but has not yet made a profit. The formula for calculating breakeven point is:

Fixed costs / (Price per unit - Variable costs per unit) = Breakeven point

Example: A company incurs a total of $20,000 in fixed costs, and each product carries $3 in variable costs. If the company sells each product for $10, it will break even after selling 2,858 products: $20,000 / ($10 - $3) = 2,858.

Many different factors go into setting a product’s final selling price, and there are several pricing methods businesses can follow. One is cost-based pricing , in which the business figures out a product’s total cost and then charges a predetermined markup. For instance, if a piece of jewelry costs $50 total to make, the company charges $75 for it to create a $25 profit. The downside of cost-based pricing is that it is easy for competitors to undercut. Another company can come along with a similar piece of jewelry and charge just $65 or $70 for it.

Another method for setting selling prices is “price-based costing,” in which the business determines how much customers will pay for a certain product, then figures out how to produce it for a cost that still leaves room for profit. Let’s say the same jewelry business conducts market research and determines that it can reasonably expect customers to pay $65 for the piece of jewelry in question. The business then determines how it can make the jewelry for just $40, so it can still make $25 in profit for each piece. This means whittling down costs, either operating costs or direct costs. In most cases, a business will look to reduce operating costs first.

One way for businesses to combat high operating costs is to create economies of scale . Economies of scale happen when a business creates enough of a product to spread out and “dilute” its fixed costs. Let’s say that a manufacturer’s monthly operating costs are $20,000. If it produces 10,000 products a month, each product carries $2 of operating costs into its total cost. However, if the company can manufacture 15,000 products in that same time period, that number is only about $1.33. This economy of scale allows the company to reduce the impact of its operating costs without actually lowering them at all.

Video

Let’s take a closer look into overhead costs in the Operating Costs and Profit lesson presentation.

Let's Review!

Now that you have been introduced to the concepts of business expenses and the impact on a company’s budget, let’s apply what you have learned. As we move forward, have you ever thought about the inputs necessary to run a business?

Citations

Citations

Reproduced by permission from NCDPI. Research, MBA (2016). LAP-OP-009, Watch Your (Over) Head (Overhead/Operating Costs) (Download). Retrieved September 13, 2020, from http://www.mbashop.org/p/845-LAP-OP-009-Watch-Your-Over-Head-Overhead/Operating-Costs.aspx